Why Canada’s big banks aren’t too worried about household debt

Canada sets interest rates Wednesday, and there’s widespread concern about what any further borrowing-cost increases might mean for consumers, their immense pile of debt and the housing market.

It’s one of the reasons to be bearish on Canada. Steve Eisman, who was featured in Michael Lewis’s book “The Big Short,” told Bloomberg TV this month investors should short Canadian financials, citing looming housing “issues.”

The country’s largest lenders are warning against overplaying the concerns. While unprecedented debt levels pose risks, they say there won’t be any major upset to the economy for a number of reasons, including the view Bank of Canada Governor Stephen Poloz won’t press ahead with higher rates if signs of stress begin to emerge.

While the debt levels are a problem, “we don’t expect it to derail the economy, just because we expect Poloz to go quite gradually, or more gradually than what might have warranted hikes in the past,” Brittany Baumann, macro strategist at Toronto-Dominion Bank said in a telephone interview.

Other reasons not to panic — according to economists at the other five major commercial banks — include households’ ability to keep monthly payments on mortgages in check, a manageable number of home-loan renewals, and the still-low cost of borrowing.

That Canadians are heavily indebted is without question. Household debt — mortgages and consumer debt such as credit cards — has swollen to $2.1 trillion, and levels as a share of income are easily the highest in the Group of Seven. Two-thirds of that is mortgages. With the central bank raising rates three times since July and with more hikes to come, there’s concern things could get messy.

Mortgage Renewals

Yet, rate rises will be gradual and it will take a while for that to flow through to households, according to Nathan Janzen and Robert Hogue at Royal Bank of Canada. More than 40 per cent of outstanding residential mortgage debt issued by federally regulated financial institutions is five-year, fixed-rate, and for those resetting now, rates aren’t much different than they were five years ago. The central bank’s effective household interest rate — a weighted-average of various mortgage and consumer credit rates — was 3.64 per cent on May 11, compared with 3.54 per cent in May 2013.

“It will take a while for the full impact of higher rates to hit household incomes,” Janzen said by email. “Household ability to pay is increasing along with interest rates. The economy looks strong, labour markets look tight, and wages have been increasing more quickly.”

For variable-rate mortgages, depending on how the loan is structured, rising borrowing costs won’t necessarily translate into higher monthly payments, but could mean instead a longer amortization period.

Canadian Imperial Bank of Commerce estimates only about 20 per cent of outstanding household debt — mortgage and non-mortgage — has so far been exposed to higher rates.

“It’s actually not a huge number, which kind of dampens the headline effect of ‘Oh, there’s such a huge amount of mortgages coming due,”‘ Ian Pollick, head of North American rates strategy, said in a phone interview.

Matthieu Arseneau at National Bank Financial says the “payment shock” from elevated household debt and rising rates will equate to a mere 0.24 per cent off aggregate disposable income this year. Considering real disposable income has grown about 2.5 per cent annually over the past decade, the shock will turn out to be more of a “slight touch on the brakes” of consumer spending, he said in recent a research note.

Poloz’s Path

Poloz has been mindful of the risks of the debt overhang. The central bank estimates that due to elevated household debt, the reduction in consumer spending “might be as much as 50 per cent more in the two years following a persistent change in interest rates.”

Such concerns have helped keep the central bank on hold since January. Poloz is expected to leave the benchmark rate unchanged at 1.25 percent this week.

“The bank is at a slower rather than a faster mentality,” Pollick said, with CIBC predicting just one more increase this year.

Derivatives trading suggests two more hikes by the end of the year, to 1.75 per cent, and Poloz has been emphatic that rates will eventually go higher. The Bank of Canada estimates its “neutral rate” is about 3 per cent.

The Bank of Montreal predicts two more rate increases this year, and three more next year. National Bank sees Poloz hiking twice more this year and twice next year. Royal Bank of Canada projects 100 basis points of increases between now and mid 2019. TD predicts one more hike this year and one in early 2019.

Robust Economy

But even as rates rise and consumers pare back spending, another mitigating factor is a relatively robust economy that can handle modest increases in rates.

Sal Guatieri at Bank of Montreal thinks the only things that could really derail the economy are a recession or a sharp increase in borrowing costs, neither of which is likely.

“We don’t foresee a recession, we still place relatively moderate odds of one occurring over the next couple of years, and we certainly don’t see a big spike in interest rates over the next couple of years,” Guatieri said.

In fact, the economy is so strong, there may be little reason for the central bank to remain cautious at all, according to Derek Holt at the Bank of Nova Scotia, particularly if it stops its rate hike cycle well below the neutral rate. He predicts the central bank will double its benchmark rate to 2.5 per cent by the end of 2019.

The increased sensitivity of the economy to rate hikes doesn’t mean Poloz “cannot continue hiking along a fairly aggressive path,” Holt said by email. “It just means there is a lower end point in this cycle and over the longer run.”